## Saturday, September 07, 2013

### Weighted Average Cost of Capital

Corporations need money daily to finance their operating activities, embark on investment activities and pay taxes, interest expense, etc. corporations can raise capital in 2 ways:

1) Bonds (debt financing)
2) Issue common and preferred shares

What if a corporation does both of these? It can issue bonds (which are a source of debt) and more common shares (which is a source of equity). But what's the right mix between the two? How much debt and how much equity should a company carry? We answer this question next:
Note: The mix of bonds (debt) and common shares of a corporation is known as its Capital Structure.

The amount of debt and equity that a company must maintain can be calculated via the WACC.

Weighted Average Cost of Capital (WACC) is therefore an overall return that a corporation MUST earn on its existing assets and business operations in order to increase or maintain the current value of the current stock. For example, if Microsoft's WACC is 15% and current stock price is 28\$, then the company must earn a 15% return on its existing assets and business operations (net income) in order to MAINTAIN the stock price at \$28. The last thing that corporations would wish to happen is their stock price falling down!

Weighted Average Cost of Capital (WACC)

The formula for WACC is:

[Rd x D/V x (1-T)] + [Re x E/V]

Rd = Bond's yield to Maturity (I/Y in Calculator)
D = Market Value (Present Value) of Bonds
(1 - T) = 1 - tax rate = Interest tax shield deductibility of interest expense
Re = Shareholder's return requirement
V = Total value of all capital (Debt + Equity)

Example

Coco Corp. has issued 10,000 units of bonds that are currently selling at 98.5. The coupon rate on these bonds is 6% per annum with interest paid semi-annually. The maturity left on these bonds is 3 years.

The company has 2,000,000 common shares outstanding with the current stock price at \$10 / share. The stock beta is 1.5, risk free rate for government bonds is 4.5% and the Expected Return on the Stock Market is 14.5%.

The tax rate for the corporation is 30%

 Bond Calculations Stock Calculations N = 3 x 2 = 6 I/Y = ? (Rd) PV = 0.985 x 10,000 x \$1000 = \$9,850,000 (D) PMT = (-10,000,000 x 0.06) / 2 = \$-300,000 FV = \$-10,000,000 P/Y = 2 C/Y = 2 Solution: I/Y = 6.56% Re = Rf + B[Rm - Rf] Re = 0.045 + 1.5 [0.145 - 0.045] Re = 0.045 + 0.15 = 0.195 (19.5%) Market Value of Equity = Stock price x common shares outstanding \$10 x 2,000,000 = \$20,000,000

V = Total Capital Structure
V = 9,850,000 (bonds debt) + 20,000,000 (equity of common shares)
V = 29,850,000

Summary of Important Terms

Rd = 6.56% = 0.0656
D = 9,850,000
V = 29,850,000
D/V = 9,850,000 / 29,850,000

Re = 0.195
E = 20,000,000
E/V = 20,000,000 / 29,850,000 = 0.67
(1-T) = (1 - 0.3) = 0.7

WACC = [Rd x D/V x (1-5)] + [Re x E/V]

[(0.0656) (0.33) (0.7)] + [(0.195) (0.67)]
= 0.01515 + 0.1307 = 0.1458 -> 14.58%

Interpretation of WACC

A WACC of 14.58% means Coco Corp. must earn a return of 14.58% on all its assets and business operations in order to MAINTAIN the current stock price at \$10 per share. If Coco Corp. wants its stock price to go higher, it must achieve a return rate greater than 14.58%
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